Look Out For Falling Stocks!

The recent gains in the US stock market have a lot of people calling it overvalued. Various analysts have pointed to many indicators that seem to show danger in the near future. Some investors are even taking their gains for the years and leaving the market. Is this the time to get out?

While the great buying opportunities of the last few years are rapidly vanishing, there are also good signals. Many individual investors still seem to be scared of stocks. If they jump back into the market after seeing these gains, they would drive it even higher.

Being cautious and informed is always good, but leaving the market entirely at this point seems premature. While I believe that gains aren’t real until you sell, this also doesn’t look like the kind of bubble peak that should keep long-term investors out of the market. The problem with leaving the market is that you limit your gains while keeping yourself open to unlimited losses. Gains that are locked in also aren’t real unless you can buy back in at a lower price later or find something else to invest in that’s just as good.

Locking In Gains

Consider the strategy of selling and going to cash or short-term bonds when you’re up 10% for the year to lock in your gains. If you did this in the early months of last year you wouldn’t have been exposed to the losses later in the year and you would be ahead of everyone else. You could do it again right about now to get the gains two years in a row. But how will it work over the next 20 – 40 years?

A book I read last year pointed out that it’s more common to have large gains or a loss than a moderate gain. If there is a loss you shouldn’t be selling (if you were comfortable owning stocks before, it only gets better when the prices are lower). So you’ll take a full loss in bad years, but if there’s a gain of 20%, 30%, or more you’re limited to getting 10% even in the best years. That gives you a higher possibility of under-performing the market.

More Protection

You might try to improve the strategy by deciding to sell at a certain point when you’re losing, so your gains and losses are limited and you have more predictable returns. To make this simple you can use options to do exactly that. By using put and call options at the same price you can limit your upside and your downside with no extra cost other than the commission on the options. This WSJ article shows that with the S&P 500 index at $1364 recently you could use this strategy so your losses are stopped at $1160 and your gains are “locked in” (and limited) at $1430.

That’s a nice predictable investment return… except that your potential losses are 3x as big as your potential gains. You could protect yourself all the way to $0 with payoffs like that. To be fair gains are more common than losses so you might have a series of gains before a loss and you can reset your protection each time. You could also adjust the option strike prices and pay a bit more so you can keep more gains. In the end it’s still a bet on a rising market and I suspect that if you did that you would spend a lot of time and commissions to get a return similar to just staying invested with no options.

No Secret Tricks

It’s wise to reduce your exposure to stocks when their prices rise quickly since they can’t continue like that forever. But if you want to get the gains that the stock market produces you need to take the risks one way or another. And getting all the risks while limiting the gains doesn’t sound appealing. Unless you’re one of the 5 people in the world who knows exactly what will happen in the next year the simplest approach is to take a long-term view of the stock market.

Anyone who has a consistent strategy based on reasonable principles has a good chance of doing well over time. But how many people who like the idea of selling now would also have sold in March 2009 to “avoid further losses”? I can’t work out a way that I could apply this consistently and get better returns than those from long-term ownership with small adjustments along the way.

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I left a much more thorough comment and then it told me I needed to login with my wordpress account and deleted it GRR lol

Anyway, great article!

To summarize, I always buy for dividend yield (along with some other considerations like P/E, P/B, cash flow, interest coverage, D/E etc). Then, whether the price goes up or down I’m paid to wait. Capital gains get taxed more than dividends. My goal is to setup a perpetual stream of dividends.

@Joe. You can also add monthly (and in some cases, weekly) income by using options against your stock-holding.
Covered call fans (who seek monthly income by selling call options at a higher strike price than the price they paid for the stock) can also get downside protection by buying a Put option with a strike price at, or slightly above, the price they paid for the stock, thereby turning the covered call into a collar.
It’s a clever stock-holder who takes income from writing (monthly or weekly) calls, and with the strike price of the option being above the purchase price, you make an additional profit if you’re assigned & they take your stock off you at the strike price.
If the market tanks, the Put let’s you exit at the original purchase price of the stock even though the current stock price is significantly lower.
The guy over at radio-active trading is the most fanatical about figuring a Put into your stock purchase, and using option writing income to offset the cost.

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This is where I write about investment/finance ideas and useful information I come across as I refine my personal investment plan. I also write a more general blog about creating and enjoying wealth at Simply Rich Life. Check it out!